Interestingly our original 2009 article on whether the Euro was overvalued discussed the chances of a Eurozone meltdown. At that time we were getting less than €1.20 to the pound. Professor Hans-Werner Sinn, President of the International Institute of Public Finance, was quoted as saying that he felt the Euro was overvalued. Professor Sin was described by The Independent as among the ten most important people who changed the world in 2011, so no light weight then. Jim O’Neil of Goldman Sachs was quoted as saying that “something needs to be done by European policy makers to stabilise the euro in the near future.”
So where are we in 2012?
The Euro has lost a lot of its value since April 2012 due in part to an increase in the success of socialist parties in many elections across Europe. Many parties are pitching themselves as anti austerity and pro growth and this is a message that has struck a chord with voters right across the EU. This is manifest in the victory of François Hollande in the French presidential elections.
The loss in value is not necessary something that European leaders are going to be in a hurry to do anything about. Put simply a weaker Euro makes European exports cheaper and that helps the manufacturing sector and makes European destinations more appealing to tourists from outside the EU. With so many European economies having little growth, hovering on the brink of recession or actually in recession it is imperative to get growth from outside the EU.
Looking back at Professor Sinn’s outlook from 2009; that the current rescue package for the euro proposed by the European Union is not the way forward and he warned that the package would effectively place responsibility for other euro states’ debts onto Germany, threatening that country’s national budget. This is exactly what happened. What Prof. Sinn could not possibly have predicted is the depth of the Portuguese, Irish, Italian, Greek and Spanish debts or the very real possibility of both default or withdrawal for the single currency. In 2009 the accepted thinking was that there was no mechanism for withdrawal from the single currency.
The weaker economies are seeing a domino effect or what is sometimes called contagion. If you owned a company in Greece that had a lot of spare cash you would probably want to protect that money by moving it out of the Greek banks. As money leaves the banks they do not have sufficient cash to make the loans that normal day to day business needs to function, that stifles growth and can force businesses into failure and increases unemployment. This is a hard cycle to break.
People outside of Greece then look at Spanish banks and think if they get into the same trouble what would happen to our savings. The natural human reaction is to take your money out of the Spanish banks before they get into trouble. So the cycle starts again but this time with the Spanish banks. The next time around people think ‘well it happened to the Greeks and the Spanish, I want to take my money out of the Italian banks before anything goes wrong with them’. This isn’t just a problem for the country’s most closely associated with too much national debt. In November 2011 Greece owed German €15.9Billion and France €41.4Billion (figures from Bank for International Settlements) by 2012 the German exposure to that debt is now €18Billion.
That describes the problem and fixing it is not easy. Ultimately the German economy is one of the strongest in the world and you can always find a safe haven for your money either in the US Dollar, Swiss Franc or to some extent the British Pound. Greece may leave the single currency but that is unlikely to happen within the next six months once done it’s done.
Ultimately there is sufficient will to stabilise the Euro but the markets, that are so important in setting the values of currencies, want to see some of the outstanding issues around sovereign debt and subprime mortgage debt with the banks resolved and signs of economic growth across the surviving Eurozone countries. All of these things will happen but they will take time and in the mean time there is little pressure to revalue the Euro upwards.
Our original 2009 article is reproduced below for reference purposes.
Are European Exchange Rates Overvalued?
Although many commentators have warned of the current downward slide of the Euro’s exchange rates with the rest of the world, others have begun asking whether the single European currency wasn’t overvalued in the first place.
The mainstream media is generally predicting meltdown throughout the Eurozone if matters do not change, but a growing number of analysts and experts have been suggesting that the latest exchange rates simply mean that the Euro is finally dropping to a more realistic value.
The president of Munich University’s Institute for Economic Research (Ifo), Professor Hans-Werner Sinn, said recently that ‘in fact, the euro is still overvalued in terms of purchasing power parity.’
He added, ‘Its true value lies at around 1.14 dollars. Also the inflation of exchange rates shows no indication that the currency is in danger, since at a current 1.5 percent it is clearly below the average rate of inflation that prevailed for the deutschmark.”
CMC Markets currency strategist Michael Hewson agreed with the argument on purchasing power parity, noting that ‘one euro is still worth more than one dollar, which doesn’t make sense.’ He said that at current levels a euro will buy less in the EU than a dollar will buy in the USA, and for both currencies to reach parity the value of the euro needs to drop below €1.20.
The chief global economist for banking giant Goldman Sachs, Jim O’Neil, also stressed that ‘for the past couple of years the Euro’s been very expensive,’ and has distorted the natural exchange rates.
He insisted that ‘something needs to be done by European policy makers to stabilise the euro in the near future.”
However, Ifo maintains that the current rescue package for the euro proposed by the European Union is not the way forward. It warned that the package would effectively place responsibility for other euro states’ debts onto Germany, threatening that country’s national budget and making it vulnerable to speculators in the foreign exchange markets.
Whether or not these experts are correct that the euro is overvalued, within its exchange rates, it holds the key to the economic recovery of the EU. Because the euro is less competitive at present than the US dollar, growth in the export markets is being made all the more difficult.